Is Your Investment Advisor Earning His/Her Keep?


by Peter Brieger

In an earlier article, we talked about the need for investors to establish one or more benchmarks for evaluating their investment performance and just how much they should pay for this performance. In this article we suggest extending that idea to include an evaluation of their Investment Advisor (IA), his/her compensation and how it effects their overall investment results.

Before starting this discussion, I want to make it perfectly clear that nothing in this world is free and that if investors receive value for their money from their IA, then they must be prepared to pay for it. My main point is that currently there is very little transparency about an IA's compensation because it is included with a fund's other operating costs in a fund's Management Expense Ratio (MER). As very few investors really know the real costs, they cannot make a proper evaluation.

In fairness, the current compensation programs and the levels of that compensation were not created by the IAs. They were for the most part created by the fund management companies to encourage IAs to sell their funds. As long as funds were outperforming, not many people cared about MERs. However, as pointed out in my earlier article, fewer and fewer seem to be outperforming and their MERs are still rising.

Nevertheless, the basis and disclosure of an IA's compensation is at the heart of the issue. In my view, it is completely contradictory to expect totally objective investment advice in a system where an IA is rewarded on the basis of the volume of transactions, and the higher the volume, the higher an IA's commission-in total and on a percentage basis. In today's market where clients are more sophisticated, we think for accounts with more than $50,000, a fee-only form of compensation is the only acceptable method. Full, plain and true disclosure will enable an investor to properly evaluate an IA's performance.

For purposes of discussion, I have divided the forms of an IA's compensation into three parts.

The commission on the initial transaction can be either a front-end load, the level of which is agreed upon by the investor and his/her IA, or through a Deferred Sales Charge (DSC) where the client initially pays nothing but the IA's firm receives an immediate commission from the fund company. It is usually between 4.0% and 5.0% of the value of the initial sale. Providing investors stay with that fund or another in a fund company's family, then after a period, usually five years or more, the DSC disappears.

The ongoing trailer/service fee (TSF) is a fee paid by the fund company to the IA's firm presumably for the ongoing investment service and advice the IA imparts to the investor. The TSF varies depending on whether a fund is purchased on a front-end load or on a DSC basis.

Transaction or switch fees are sometimes charged when a client switches from one fund in a fund company's family into another. I do not know how frequently in today's competitive environment these fees are charged.

One way or the other, the investor is paying this compensation and it is totally included in the MER. However, as will be pointed out, there are some additional indirect costs. Both impact performance. To try to quantify this impact, let's review the different types.

Front-End Loads or DSCs
If a front-end load averages 2.5%, it means that the investor is starting with a smaller capital base than he/she might otherwise start with. If the IA receives a TSF which can range from 0.25% to 1.0%, it is part of the MER, including whatever administrative costs and bookkeeping are sustained by the fund company to maintain the TSF payouts. Based on a conversation with a particular fund company, those costs could be about 0.05% per year.

If a fund is sold on a DSC basis, then the TSF is likely to be about 0.5%. However, in addition to that cost being added to the MER, there are others. For example, if a fund company financed the commissions immediately payable to the IAs through a Mutual Fund Limited Partnership, then for the volume of funds sold through the LP, it will receive, for a period of time, an annual percent of the assets raised. While these LPs were being issued, this percent could be as high as 0.5%.

Currently commissions payable through a DSC are financed by bank borrowings, securitizations or by some other method. Regardless of what method is used, the costs of these financings are included in the MER and currently represent an estimated annual cost of 0.05%.

Therefore, one way or other, compensation costs can lead to estimated increases in the MER of 1.10% or more per year.

Also, there are other additional 'marketing' costs that benefit IAs and are included in a fund's MER. For example, there was the $100,000 payment required by each of a number of fund companies to a mutual fund/securities dealer to finance that dealer's 'educational' trip for its IAs to some exotic locale in the South Pacific. On a lesser note, fund companies from time to time assist dealers and their IAs with financial assistance at venues such as financial trade shows. On a crasser note, little tokens such as small luggage, golf shirts and wind breakers may show up as signs of a fund company's appreciation. That, of course, is all part of the MER even though it is not thought of as direct compensation.

At this point, lest anyone think that I am 'simon pure', I admit that several years ago, I accepted financial assistance from a number of fund companies with which we did business to help finance the firm's participation in several trade shows. We did not accept assistance from any fund company whose funds did not meet our criteria. In retrospect I now think it was wrong, I am embarrassed, and it has been on my conscience ever since. On other issues, we have never accepted 'trips' and routinely send back all windbreakers, golf shirts etc with a note to please stop sending them.

Switch Fees
Obviously, any fees charged to an investor for internal switches within a fund company's family reduces the capital available for reinvestment. Therefore, aside from the immediate cost, it reduces an investor's long-term total return. In my view, such fees are outrageous and border on unethical. The compensation for any switches should be included as part of the TSF.

In summary, if an investor purchases a fund on a front-end load basis, not only is his/her capital available for reinvestment reduced, it has cost him/her potentially long-term returns. For example, if the load is 2.5% and is amortized over five years, then it would be an indirect cost of 0.5% per year in addition to the MER the investor is paying. Therefore, the overall compensation cost to investors would be 0.5% (amortization) + up to 1.0% (IA's compensation) + 0.05% (additional administration) for a total annual cost of 1.55% over and above whatever the basic fund management costs might be. Furthermore, if the front-end load is 2.5% as per our example, and if a fund's annual net return is 10.0%, presumably the lost opportunity cost would be an additional 0.25% per year (an indirect cost not in the MER). Therefore, within a fund's MER, an investor is paying up to 1.10% for compensation, and as shown, an additional 0.75% indirectly (0.5% + 0.25%).

For funds purchased on a DSC basis, the costs to investors are much the same but it can be argued that their advantage over a front-end load is that an investor starts off with 100% of his/her capital. However, the investor pays for the financing costs of commissions, so the total costs are much the same as for a front-end load.

As it turns out, I don't have a huge problem with an IA's annual compensation of up to 1.0% if the IA is meeting whatever criteria the investor and the IA have agreed to. However, as it stands now, investors have no say in the level of an IA's compensation. Also, as pointed out, there can be additional costs associated with current compensation programs. It would be far more equitable if that fee could be eliminated from a fund's MER (at the moment it is like a union 'check-off') and left open to negotiation between the investor and the IA. That could reduce a fund's basic MER to about 1.25%. Also, as explained below, it can be more tax effective for the investor.

Finally as pointed out earlier, today's investors want and must have full disclosure of all costs including the basis of an IA's compensation.

There are far too many examples of investors who were told that the purchase of funds on a DSC basis would 'not cost them anything'. The fact that if they moved from a DSC fund to a fund outside that fund's 'family', they would pay a commission, was conveniently not mentioned by the IA. I think this is ethically and professionally unacceptable. We see ever-increasing numbers of new clients who are stuck in funds they no longer want or should not own, but are reluctant to pay a DSC to get out of.

Future Trends
The first trend which is long overdue and which is gaining momentum is a switch from a commission or transaction-oriented compensation system to a totally fee-based system. It is not just boutique investment advisory firms like GlobeInvest which think that way but many of the major investment dealers in both the U.S. and Canada. For example, at a private lunch recently with the senior management of a leading Bay Street firm, we were told in no uncertain terms that in a number of years their advisory business would be entirely fee based.

I suppose that the term 'fee only' can mean different things to different people, so let me spell out what it means at GlobeInvest. We purchase all funds on a front-end, '0' (zero) load basis and don't expose our clients to a DSC. We charge an annual fee of no more than 1.0%. If we receive any trailer fees, they are disclosed to the client and are deducted from the annual fee agreed upon. If we purchase stocks or bonds for clients, we do so through third parties at competitive rates and do not share in the commissions.

The second trend will eventually lead to a separation of fees so there is complete transparency of all costs to investors. They will be able to choose what they want and what they will pay. Again I repeat a quote from Bob Krembil of Trimark, 'Mutual fund management fees have to start coming down. At some point, fees may be unbundled, with separate charges for investment management, distribution and advice.' Difficult as acceptance of that outcome might be, it is coming. I think all industry participants will benefit from it.

In the last article I offered a few new year's resolutions. Here are a few more:

For MoneySaver readers:

  • If a fund pays a trailer fee, find out what the fee is, and on a new fund purchase, negotiate an annual advisory fee you would pay directly to the IA's company; but make sure you reduce it by the amount of trailer fees the IA's company receives.
  • That expense will be tax deductible for non-RRSP accounts. For RRSPs, it can be paid by withdrawing the amount from your RRSP without it being taxed as income.

For fund companies:

  • Effective ASAP, eliminate annual service fees, thus lowering a fund's MER by as much as 1.0% or more per year. It will make your funds more competitive.
  • If that is impossible and I understand it likely is, then start new funds which do not pay trailers and have minimal marketing costs.
  • These new funds should be sold front-end load only and should never be sold on a DSC basis.
  • MERs should, if possible, be in the 1.25% range. Any compensation to the IA would be left for negotiation between the IA and the investor.
  • The initial small size of a new fund with a lower MER may lead to enhanced performance. Also, you may broaden your market as 'fee-for-service' investment planning increases in popularity.

Peter Brieger, HBA, CFA
GlobeInvest Capital Management Inc
20 Queen Street West, Suite 3206
Toronto, Ontario M5H 3R3
Tel: (800) 387-0784

Originally published in the February 1998 issue of:
Canadian MoneySaver
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